Gold and bonds agree

Commentary: Bond investors expect inflation to heat up

ANNANDALE, Va. (MarketWatch) -- Bill Moyers, the famous television commentator, is reported to have once said that journalists get to "learn in public."

That certainly applies to me and what I've written in past columns about the bond market and inflation.

I had argued in previous columns that inflation might not be heating up, despite evidence to the contrary from lots of different sources -- including the price of gold bullion
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which soared to a new high over $1,000 an ounce on Thursday.

I had based my argument on the narrowing yield spread between regular Treasury bonds and the special type of Treasuries known as TIPS. The only apparent difference between these two kinds of Treasury securities is that TIPS' interest rates are protected against changes in the inflation rate. So I had assumed that we can deduce the bond market's expectations of future inflation by comparing their yields.

Using that logic, I had argued that inflationary expectations were coming down, not up. So, I concluded, either the gold market or the bond market was going to be spectacularly wrong about inflation. See Jan. 15 column

My argument appeared to make perfect sense, and I certainly was not the only one that was making it.

But I now believe that I was wrong. Interpreted correctly, the message of the bond market actually is that inflation is indeed going up.

Though that doesn't guarantee that inflation is getting worse, it does mean that both the gold and the bond markets are in agreement that inflation has become more of a problem in recent months, not less.

My education came courtesy of Stephen Cecchetti, a former director of research at the New York Fed and currently professor of global finance at Brandeis University. In an interview, Cecchetti pointed out that other factors must be introduced into the equation when deducing the market's inflationary expectations from the spread between the yields on TIPS and regular Treasuries. See Cecchetti's Website

The most important of these other factors right now is the relative size of the markets for TIPS and regular Treasury securities. Whereas the market for the latter is huge -- larger, in fact, than the equity market -- the TIPS market is several orders of magnitude smaller. This means that, relative to regular Treasuries, TIPS yields must be higher to compensate investors for this relative illiquidity.

And that, in turn, means that the spread between the yields on regular Treasuries and TIPS will understate the bond market's expectations of future inflation.

Complicating factors even more is that this so-called illiquidity premium is not constant. So economists have had to devise elaborate econometric models to adjust for it and other factors. And those models are showing inflationary expectations to have dramatically worsened in recent months.

One of these elaborate models was devised by statisticians at the Cleveland Federal Reserve. According to their model, the bond market's implicit expectation last September was for inflation over the next ten years to average 2.37%. Currently, in contrast, the bond market is expecting it to average 3.46%. See Cleveland Fed Website

That is a huge increase for such a short period, especially given that it represents average inflation over a 10-year period.

The bottom line? Contrary to what I have written in the past, the bond market would appear to agree with the gold market that inflation has gotten dramatically worse in recent months.

This in turn suggests that the explosive bull market is being built on solid fundamentals.

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